Recently a friend approached me when considering a career change. The new position would be with a Silicon Valley startup, and the new compensation arrangement would involve some level of salary, but a reasonable amount of equity compensation coming from company stock options. In taking the job, they would be taking a pay cut. Would the option compensation more than make up for that? How could they know?
Variable compensation comes in multiple structures. Without seeing a particular contract, it is very difficult to make a judgment about the very real life decision of going to work for a new company. To make a recommendation for the next steps, I gave him a framework for thinking about equity compensation more broadly.
That framework starts with the understanding that they were now investing in the future stock market fortunes of his company. They would be an owner, not just an employee. Not just an owner, but also an entrepreneur. It is easy to think that an ownership stake in the company is a one way ticket to success, but in fact, success is far from certain.
There are several types of risk with stock compensation.
- The company doesn’t grow as expected, never goes public, or goes bankrupt.
- You don’t enjoy the work or the work environment.
- Stock compensation “vests” over time, so there is a delay in when you receive equity compensation.
- There is no certainty that the value later will be greater than the value today.
- Taxation is more complicated, and will probably necessitate hiring a professional tax preparer.
Stock options allow participants to benefit from the growth of the company in the long term. Stock options may be the most attractive benefit in a new company; they’re probably the area you know the least about. Making an analysis of the underlying value is complex.
Ultimately, you must consider new and different risks when taking a job with this compensation structure.
Features & Risks of Equity Compensation
Each type of option has different tax implications. Usually, you will need to pay taxes when you exercise or sell stock options. What you pay will depend on what kind of options you have and how long you wait between exercising and selling. With smart planning over a multi-year period, some forms of options can provide substantial tax advantages.
Vesting is how long it will take for the compensation to become yours. An employer may grant an employee options, but it is not until they are fully vested that you take ownership. If you plan on being with a company for a long period of time then the vesting schedule may be less relevant to you. On the other hand, if you leave sooner, the vesting schedule may restrict how much of the quoted compensation you will actually receive. Vesting schedules are set up by the company and can differ with each equity grant.
Earning compensation in the form of company stock can be highly lucrative, especially when you work for a company whose stock price has been rising for a long time. At the same time, you need to be attentive to whether you have too much of your personal wealth tied to a single company’s performance. Stock value may be volatile and this may make you uncomfortable.
Furthermore, when that company is also your employer, your financial wellbeing is already highly concentrated in the fortunes of that company. Your career development, your benefits, and even allocations in company savings are all dependent on the company’s success. Not only could the stock value fall, but you could lose your career and livelihood.
A Golden Egg – Or a Paperweight?
As for my friend, after a few days of thinking it over, they made the leap and took the new role. Only time will tell if they truly found their golden goose, but for now, the thrill of the new opportunities and a fancy coffee machine in the breakroom have them sold. As financial advisors, we steer on the side of caution and look for ways to minimize and reduce risk. In this instance, understanding the balance of both the risks and the benefits inspired them to confident action.
About Daniel Smyth, CFP®, CPWA®
Daniel Smyth is a Lead Advisor with North Berkeley Wealth Management. He helps clients articulate and reach their long-term financial goals.
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